Question

Motor Homes Inc. (MHI) is presently enjoying abnormally high growth because of a surge in the demand for motor homes. The company expects earnings and dividends to grow at a rate of 20% for the next 4 years, after which there will be no growth (g = 0) in earnings and dividends. The company’s last dividend, D0, was $1.50. MHI’s beta is 1.5, the market risk premium is 6%, and the risk-free rate is 4%. What is the current price of the common stock?

Answer 1

To calculate the current price of the common stock, we can use the Gordon Growth Model. The current price is -$25.71.

Step-by-step explanation:

To calculate the current price of the common stock, we can use the Gordon Growth Model. The formula for this model is:

P = D1 / (r - g)

Where P is the current price of the stock, D1 is the expected dividend at the end of the first year, r is the required rate of return, and g is the growth rate.

In this case, the expected dividend at the end of the first year (D1) can be calculated using the formula:

D1 = D0 * (1 + g)

First, let's calculate D1:

D1 = 1.50 * (1 + 0.20) = 1.80

Next, we need to calculate the required rate of return (r). This can be done using the formula:

r = risk-free rate + (beta * market risk premium)

Plugging in the values, we get:

r = 0.04 + (1.5 * 0.06) = 0.04 + 0.09 = 0.13

Finally, we can calculate the current price of the common stock (P):

P = D1 / (r - g) = 1.80 / (0.13 - 0.20) = 1.80 / (-0.07) = -25.71

Therefore, the current price of the common stock is -$25.71.